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2 Intertemporal trade and the current account What determines when countries lend and when countries borrow in international capital markets? The current account (driftsbalansen) Let B t+1 be the value of an economy s net foreign assets at the end of period t. De nition of current account: net increase in foreign asset holdings or where NX t denotes net exports CA t B t+1 B t (1) CA t = NX t + rb t (2)

5 The simplest possible model: small open economy two periods, labeled 1 and 2 one good at each date endowment economy: output in each period is given: Y 1 and Y 2 all individuals are identical, population size normalised to one. perfect foresight (no uncertainty)

8 This is the consumption Euler equation: at an optimum the consumer cannot increase utility by shifting consumption between periods. A one unit increase in consumption in period 1 increases utility by u 0 (C 1 ) Alternatively the consumer can save in period 1 and get () extra units of consumption in period 2 which increases utility by (1+r)u 0 (C 2 ) Consumers have incentive to smooth consumption over time Rearrangement yields u 0 (C 2 ) u 0 (C 1 ) {z } Marginal rate of substitution of present for future consumption = 1 {z } Price of future consumption in terms of current consumption Optimal consumption plan found by combining (10) and (7)

9 What determines whether a country runs a current account de cit or a current account surplus? Autarky real interest rate r A : interest rate that would prevail in economy which could not borrow or lend internationally In autarky: C 1 = Y 1 and C 2 = Y 2 u 0 (Y 2 ) u 0 (Y 1 ) = 1 A (11) An increase in Y 1 or a fall in Y 2 causes the autarky interest rate to increase If Y 1 = Y 2 =) = 1 1+r A Gains from intertemporal trade as long as r 6= r A

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